Uncle Sam can't afford a strong economy

The feel-good story of 2013 could become a major headache in 2014. Here's how investors can begin to defend themselves.

By StreetAuthority Jan 9, 2014 3:16PM
Image: Taxes (© Peter Gridley/Photographer)By David Sterman                                                             
By the time the U.S. budget deficit reached $1.4 trillion in fiscal (October) 2009, alarm bells were sounding everywhere. 

Unless the government could get its fiscal house in order, the future promised years of misery as the U.S. kowtowed to its bondholders in China, Japan and elsewhere.

But this crisis simply never came to pass. Thanks to a range of factors for which both political parties can take some credit, the budget gap has already narrowed sharply. 

According to the Congressional Budget Office (CBO), the budget deficit will fall even further in fiscal 2014 and 2015.

                                                          A Fast-Shrinking Deficit

In another bit of good news, the recent era of very low interest rates has enabled Uncle Sam to keep interest payments in check. Five years ago, the government was paying a roughly 4% interest rate on its debt. That figure has fallen by more than 150 basis points since then.

*CBO estimate
The net result of the drop in interest rates: Uncle Sam has saved nearly $200 billion in annual interest expense (in light of the growing total debt since then and assuming interest rates had stayed constant at 2008 levels).

The tougher road ahead
Yet just as many investors have begun to stop thinking about our massive debt (which totals $12 trillion when Social Security liabilities are excluded), a pair of factors may conspire to make this a prominent concern again in 2014, and a real crisis within a few years.

And the blame goes to the resurgent U.S. economy.

As I noted in another column last week, the U.S. economy enters the new year on firmer footing, with some economists anticipating GDP growth in excess of 3% this year. And that should start to push interest rates on longer-term bonds higher. Interest rates on shorter-term debt, known as short rates, are likely to stay quite low for at least the next 12 to 18 months.

But that creates a real conundrum. If the government tries to keep its borrowing costs as low as possible by issuing short-term bonds and Treasury bills, then it will need to roll over that debt in a few years anyway, at which time even short rates may be notably higher.

If the government aims to avoid that scenario and instead issuer longer-term bonds, then it will already see higher interest rates as 2014 plays out. It's safe to say that the era of federal borrowing costs below 2.5% has come to an end.

Every 1-percentage-point increase in the government's borrowing costs raises interest expenses by $120 billion. And that assumes that the size of our debt will remain constant. But that won't be the case: Even though the deficit is shrinking, total debt is growing, and the CBO ominously warns that the deficit will start to grow at an accelerating pace, thanks to increases in mandatory entitlement spending.

The CBO's conclusion: "The government's net interest costs are projected to more than double relative to the size of the economy over the next 10 years -- from 1.3% of GDP in 2013 to more than 3% by 2023."

To keep that from happening, the government would need to find an additional $2 trillion in cumulative savings over the next decade, according to the CBO, which "would require significant increases in taxes, significant cuts in in federal benefits and services, or both." Sadly, the two major parties appear to have already gone as far as they are willing to bring the deficit down to current levels. Higher taxes or deeper spending cuts won't likely be on the table until after this fall's mid-term elections.

The CBO sums up its recent analysis of the debt situation with a fairly grim conclusion: "How long the nation could sustain the projected growth in federal debt relative to the size of the economy is impossible to predict with any confidence. At some point, investors would begin to doubt the government's willingness or ability to pay U.S. debt obligations, making it more difficult or more expensive for the government to borrow money."

That was a concern expressed a few years ago when the budget deficit reached staggering proportions. Though the size of the deficit has become more manageable, the size of the debt has not. The stock market has learned to ignore this issue, but rising interest rates in 2014 threaten to bring the issue right back to the fore.

Risks to consider: As an upside risk, the U.S economy may be able to sustain an extended period of GDP growth in excess of 3%, which would help boost tax revenues that can largely offset higher interest expenses.

Action to take: How rising interest rates in 2014 impact the perception of this trillion-dollar issue could be a big factor for investors to consider as they make portfolio adjustments. In a worst-case scenario, bond vigilantes could lead to a rapid scare in bond markets, as they did 20 years ago.

That means investors need to avoid becoming too complacent -- and should stress-test their investments to be sure that interest-rate risks are manageable. For example, bond funds that own long-duration bonds could prove vulnerable. And yield-producing investments, such as MLPs (master limited partnerships) and REITs (real estate investment trusts), which underperformed in 2013, could see further selling.

More from StreetAuthority
Jan 9, 2014 4:59PM
How convenient for the government that they save two or three hundred billion a year because they print money and manipulate interest rates low. Savers lose at least that much each year because of the low rates. So the government is really taking money from savers. How un-government -like.

Are these guys on drugs or something ???


The economy is getting worse everyday and normal people are not able to make it


There is no saving the economy now





Jan 9, 2014 4:54PM
Yet another bullsh*t, propaganda article from the media puppets...
Jan 9, 2014 5:28PM
Republican OR Democrat, every administration spends money like there is no tomorrow. When is the last time we had a budget surplus or just broke even?

We are 16 trillion dollars in debt. In order to pay that off you need many years of balanced budgets and a specific plan to pay it off. There is no political motivation for that on either side. Lets face it. Politicians will always use their power to make money in some way. 

Eventually our debt will be too big to deal with. The dollar will crash. The economy will crash. The world we live in will be changed forever. Democracy cannot survive when we have given our government the power to crush the dollar. 

Please look into voting for politicians that want smaller government. Thanks
Jan 9, 2014 5:07PM
New world order is on its way, get ready for it. USA will go down very soon, blaming each other all you want, it is not going to work. 
Jan 9, 2014 5:56PM
My late Grandpa always told me "This country was born in revolution and it's going to take another one to save it". I think he may have been right.
Jan 9, 2014 5:26PM

The regime has things so screwed up they're turning common sense into B.S.  Wow!  If you think this is bad wait till 2015 when obamacare really kicks in.  Bye bye middle class.

Jan 9, 2014 5:58PM
The middle class, which is disappearing, has been squeezed by high taxes, high food prices, high energy prices, high property taxes, high healthcare cost, and wages are not keeping up with inflation.  Most US corporations still have factories in China and avoid paying their share of taxes.  Google has saved billions in taxes by off shooting to other third world countries.  

You can't have the middle class taxed to death while US coporations don't pay anywhere near their share of taxes.  We are a nation of the elite rich and poor.  In 1972 1 out of 49 americans were on food stamps...today 1 out of 6 americans are on food stamps.  Of course our government doesn't want that fact to be widely known.
Jan 9, 2014 5:36PM
Obama,need I say more. This Nation has never had a more foolish man running it business while it's Media stands by his every mistake.
Jan 9, 2014 5:29PM
It's funny all the rage these pathetic articles cause when you can stop at the headline ...
"Uncle Sam can't afford a strong economy
The feel-good story of 2013 could become a major headache in 2014."
So ... does that me we are better off with a failing economy? In other words, don't take what these guys write too seriously - they rarely make sense. 
Jan 9, 2014 5:32PM

Whenever I read a report from the CBO, I'm reminded of the joke about the business owner who was looking for an accountant. After interviewing several people who answered his question "How much is two plus two" as "Four" he finally found his accountant, whose answer was "How much do you want it to be?"

CBO projections are drawn on an etch-a-sketch.

Jan 9, 2014 5:36PM
Jan 9, 2014 5:39PM
Tax and spend Democrats have written the obituary for the USA already. Nothing short of an armed revolution will save the country.
Jan 9, 2014 5:57PM
Quit paying minorities to have baby's!!!! SAY NO TO "baby mamma's"!!!!!!!!!
Jan 9, 2014 5:31PM
And your friendly Fed. Reserve has kept rates paid on deposits owned by savers so artificially low for so long that Uncle has in effect been stealing from the middle and lower classes to support its debt habit.  And there is going to be all hell to pay if interest rates went to, say, 4% on short term stuf because Uncle will be sending ocean going freight containers full of Ben Franklins to China to make interest payments. Then they will scream they need more tax revenues, because it is a matter of religion with democrats that you never cut spending.
Jan 9, 2014 5:22PM
So it seems no matter who wins in 2016  they will be responsible for the deficit going back up from where its at presently without even signing one bill into law 
Jan 9, 2014 5:47PM
MSN you have lost all creditability with me. REALLY...figures don't lie but liars figure. This article has no truth to it at all.
Jan 9, 2014 5:41PM

So, if we can't afford a strong economy, we have the right guy as President???

Obama Media Minions spinning again for the gullible.

Jan 9, 2014 5:51PM
Rid of the social agenda rather than the economic from Obama whos doing things just for the vote for his band of nuts!!!! I don't care if gays can marry!!!!! Who gives two shi-s???? We need jobs! No to amnesty! Great decision more people to be out of work and nie to a household paying no taxes! All the illegals are getting benefits as it is! Get them the hell out of the country!
Jan 9, 2014 5:36PM
2013 Debt was 1 trillion only reason for the 680 Billion is due to the ceiling being hit in March of 2013  and not being raised until the shutdown was over in early Nov 2013 and the debt went up over 300 billion in one day. 
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